ANZ: Don't bank on commodities to drive the Australian dollar higher

If you’re betting on improved commodity prices to push the Australian dollar higher, think again.

It’s already been built in to market pricing, meaning other factors will have to take over in order to propel the currency higher according to ANZ strategists Katie Hill and Daniel Been.

They believe interest rates, rather than commodity prices, will have to move in favour of the Aussie to drive further gains from here.

“Our view is that the rise in commodity prices over the last year is already priced into the AUD,” the pair wrote today, citing modeling by the bank.

Hill and Been suggest that the 20% lift in the RBA’s commodity price index in 2016 has resulted in the fair value level of the Australian dollar lifting by 2.5 cents, something they believe leaves it around the right spot.

“With the AUD now trading broadly in line with fair value, this suggests the higher commodity prices are reflected in the current level of the AUD.

The chart below tracks the relationship between the AUD/USD spot rate and the RBA’s commodity price index:

Along with the belief that the rally in commodity prices is already priced in, Hill and Been think that price gains will be capped from here given “increased supply and a likely reduction in steel demand given that Chinese authorities have recently introduced new property restrictions in some major cities”.

With a commodity-driven Aussie dollar rally unlikely to eventuate in their opinion, Hill and Been suggest the greatest upside risk for the currency will be a shift in Australian interest rate expectations.

“The greater upside risk for the AUD would be if rates markets begin to price in RBA hikes,” they wrote, emphasising that this is not ANZ’s “base case”.

“The front end (of Australia’s yield curve) has sold off and now has just roughly 10 basis points of cuts priced in over the next year reflecting the RBA’s recent emphasis on the flexibility of the inflation targeting framework,” they say.

“While a stronger than expected CPI print could see the front end move to a neutral stance on the RBA, it is not likely to be the catalyst to price in hikes.

“A more neutral stance in the front end would likely see the AUD trade towards the top of recent ranges, but would not justify a break higher,” they wrote, suggesting a figure of around .7800.

In April, the AUD/USD hit its 2016 high, at least so far, briefly trading at .7835.

According to Hill and Been “absent a broad reassessment of the degree of slack in the economy and of the underlying inflation trajectory, we think the AUD is unlikely to sustainably break above recent range highs”.

The other major consideration in the months ahead is the other part of the AUD/USD equation, the US dollar, in particular the outlook for US interest rates.

With market expectations for a rate hike in December oscillating at around a two-in-three chance, any shift in those expectations — be it higher or lower — will likely create an opposite reaction in the AUD/USD in response.